The Trouble With Quants

Back in 2005 I met Emmanual Derman at a Grant's conference. He had recently published My Life as a Quant (Reflections on Physucs and Finance). He developed an interest rate model with Fisher Black. He showed an H-bomb respect for the power of the derivative products he was messing with.

The trouble with the general practitioner of technology and mathematics in financial markets is analyzing correlation as causation. We have touched on this subject before in Pavlovian terms. Thomas Pynchon distilled Wernher von Braun's theory that there is a lack of total extinction of a conditioned response into the epic Gravity's Rainbow. The correlation between markets in this cycle is widely discussed (as was the mortgage market) but usually in observational terms. Hedgie #1 "The markets are highly correlated" Hedgie #2: "I just bought a Bentley!"

The risk comes from the causation mistake. Presently. the SP shows near perfect tracking to the direction and magnitude of the Euro exchange rate. Few would spin this silliness into a causal story. Not so for interest rates. In the US crisis cycle. yields and equity prices are positively correlated. The attenuated system de-leveraging has led some to now advance the idea that higher rates are thus the tonic for higher growth. The concept is gaining proponents despite the painful evidence to the contrary in peripheral Europe. Our take away from the correlated - not causal - environment is to focus on growth not markets. Growth is the key. Recent risk market adjustments are more a rejection of end of the world collapse than a growth endorsement. The trouble with the Quants shows no sign of abating.